Inflation: demography vs technology

Inflation breaching 3% has worried some investors, but overarching economic forces should keep prices relatively anchored, argues chief investment officer Julian Chillingworth.

UK inflation crept 10 basis points higher to 3.1% in November, breaching the Bank of England’s target range. There has been some consternation about this, but we believe CPI has peaked and is unlikely to go much higher. Higher inflation in the UK, compared with muted CPI in other advanced economies is mostly due to the large post-Brexit move in sterling, which has slowly seeped through the supply chain to consumers. Rising petrol costs, gas bills and unseasonably high airfares pushed the rate over the 3% mark in November, but core inflation in the UK (stripping out energy and food prices) has been flat at 2.7% since August. Worldwide, inflationary pressures are subdued – or at least, finely balanced with countervailing deflationary influences. There is a whole mix of forces acting on inflation, from demographics to technological innovation and an increasingly globalised market in services.

Since the 1990s, the spread of globalisation lowered the cost of manufactured goods, such as toys, dishwashers and cars, but it did nothing to stop the rising cost of services, commodities and energy. As emerging markets develop further, taking a greater share of IT, design, legal and other professional work, the next few decades may be an era of slowing inflation – or even deflation – in services. Meanwhile, the UK population is changing. The country is ageing, like much of the Western world, but there is another important aspect to this demographic shift. Up till now, ageing has had a deflationary effect on the UK, but not for the reasons that most assume. Contrary to some assumptions, people don’t tend to consume less as they age. But the middle-aged save more relative to what they spend. These are the prime income-generating years where money is left over and people prepare for retirement. The proportion of the British people between 30 and 64 years old peaked in 2005 and is set to decline from here. As this large cohort of people flows from work into the golden years, the amount they consume relative to income will rise. That will  make them an inflationary influence on the economy. The mix of things they spend money on will change too – healthcare, for example, will be in huge demand.

This large scale shift from working age to elderly will also drive up the dependency ratio in the coming decades. That’s the number of young, elderly and infirm for every working age person in the country. This ratio had been falling (fewer dependents per worker) since the 1960s as people had fewer children and more women joined the workforce. It troughed about 10 years ago at around 51 dependents for every 100 workers and is forecast to accelerate upwards to about 70% by 2050 as more people retire than start work. A smaller labour pool should lead to faster wage growth as employers try to attract scarce workers. However, that may be mitigated by increasing automation.

The path of inflation is extremely important for both investments and financial planning. That’s why our research team has completed a comprehensive – and comprehensible – report into what drives inflation and its likely path over the next couple of decades. We have also built a personalised inflation calculator that uses an itemised budget to find your real inflation rate, rather than the CPI average. The difference may surprise you …
 

 

1 month

3 months

6 months

1 year

FTSE All-Share

-1.7%

-0.3%

-0.2%

13.4%

FTSE 100

-1.8%

-0.7%

-0.7%

12.3%

FTSE 250

-1.2%

1.4%

1.2%

16.9%

FTSE SmallCap

-0.8%

1.7%

3.5%

20.5%

S&P 500

1.0%

2.3%

5.4%

12.7%

Euro Stoxx

-1.6%

0.1%

3.4%

27.2%

Topix

1.1%

4.5%

8.8%

17.0%

Shanghai SE

-3.9%

-6.1%

4.7%

-1.9%

FTSE Emerging

-1.7%

-3.2%

6.4%

18.4%

Source: FE Analytics, data sterling total return to 30 November
 

Retail therapy

Investors dashed into retailers and banks toward the end of November, rattling technology companies after a year of tremendous upward momentum.

A strong Thanksgiving Weekend for US retailers, both in store and online, helped inject some optimism into an industry that has been bedeviled by Amazon and other ecommerce rivals for years. This optimism was boosted further by the passage of tax reform bills through both chambers of Congress that brought lower corporate taxes much closer to reality. Republicans are now working to reconcile both bills, which would then be ratified by the President.

American retailers pay much higher effective tax rates than other sectors, so the proposed tax cut would boost their earnings by relatively more. The same goes for US banks, whose shares have also leaped upward in the past couple of weeks. If you listen hard enough, you can almost hear “reflation” whispering in the wind …

Technology companies, meanwhile, have low effective tax rates so the tax cut wouldn’t offer much to them. In fact, a last-minute alteration to the Senate bill threatened their research & development tax credits – which may put upward pressure on their effective tax rates. This meant IT slumped sharply as investors sold heavily to buy up value stocks. However, this was fleeting. The IT sector has since recovered most of its losses and we believe its outperformance is likely to continue. Tech company revenues are growing rapidly and steadily, despite being some of the largest businesses the world has ever seen. Artificial intelligence and computing power are improving and spreading into every facet of industry, which should support further expansion.

Retailers have been this cycle’s pariah, lagging far behind the returns offered by growth companies, particularly the tech giants. While it’s true that the strong Thanksgiving season shows the old bricks and mortar model of retailing isn’t dead, we feel this move to retailers is premature. Global growth is likely to be lower next year as advanced economies slow. In this environment, we feel scarce growth will push investors back to those quality companies that control their markets and have pricing power. Retailers are in the business of enticing people into shops; nowadays it takes an annual shopping festival and sharp bargains to do so. Neither lumpy cash flows nor razor-thin margins are good for the value of earnings.

We have seen this “reflation” trade before: expectations of accelerating inflation, GDP growth, faster interest rate hikes and increased wage growth would lead to a different kind of world that would reward value stocks. It always petered out after a month or so. In mid-December, the US Federal Reserve raised its interest rate from the 1.0-1.25% band to 1.25-1.5%. The last time it moved the rate higher was six months ago. So much for a quickened pace of monetary policy.
 

Bond Yields

Sovereign 10-year

Nov 30

Oct 31

UK

1.33%

1.33%

US

2.41%

2.38%

Germany

0.37%

0.36%

Italy

1.75%

1.83%

Japan

0.04%

0.07%

Source: Bloomberg
 

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